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Because most people do not have the cash necessary to buy a home, home buyers may take out a mortgage, which allows them to live in the home while making payments on its purchase price.
Simply put, a mortgage is a loan secured by real property (usually a house and the land it’s on). A mortgage is much like any other loan: It has an interest rate that reflects the lender’s risk and a deadline for when it must be paid off. For most mortgages, that period is 30 years.
There are two basic types of mortgages: fixed rate and adjustable rate. Fixed-rate mortgages are the most common, with the principal (the actual cost of the house) and the interest rate remaining the same over the life of the loan. Conversely, an adjustable-rate mortgage (ARM) is based on an economic index; the interest rate fluctuates depending on that index.
One type of mortgage that is rare is a balloon mortgage. A balloon mortgage has a fixed interest rate typically lower than any other type of mortgage. After a certain time (usually between five and seven years), the loan payments will “balloon,” requiring the borrower to pay off the entire balance of the loan. This type of mortgage is not attractive to home buyers unless they make a substantial down payment, plan to refinance the mortgage or plan to sell the home before the balloon payment is due. A balloon mortgage is risky because if the borrower cannot pay off the balloon payment, he or she risks foreclosure.
A mortgage involves two important legal documents: a promissory note and either a mortgage document or deed of trust.
Promissory Note: The promissory note (also called a mortgage note or real estate note) is a note the buyer gives to the lender promising to repay the amount of the loan plus interest. The note also states the amount of time the buyer has to repay the loan and what action the lender may take if the buyer fails to make the required payments. The note should state the interest rate and specify whether it is fixed or variable. The note also may contain provisions such as a balloon payment.
It is important to note that the borrower’s typical monthly payment to the lender is not solely for principal and interest owed on the note. Monthly payments might also include escrow payments for property taxes and insurance.
Mortgage Document or Deed of Trust: The borrower gives the lender either a mortgage document or a deed of trust, depending on the state where the transaction takes place. Both a mortgage document and a deed of trust serve the same purposes of pledging the borrower’s title to the property as security for the loan and giving the lender a claim against the property in the event of default. A mortgage document and a deed of trust have a few key differences:
Mortgage Document: A mortgage document is used in most states, including Florida, Illinois and New York. A mortgage involves only two parties: the borrower and the lender. It creates a lien on the property, which is recorded in the public land records. With a mortgage, the borrower has full title to the property but may not transfer ownership until the debt is paid off and the lien is released. If the debt is not paid, the lender has the right to sell the property, usually through judicial foreclosure.
Deed of Trust: Many states, including California and Texas, use a deed of trust instead of a mortgage. The deed of trust is recorded in the public records to give notice that the property has a lien on it. A deed of trust involves three parties: the borrower, the lender and a third-party trustee, such as an attorney or title insurance company, who holds temporary title until the debt is paid and the deed of trust is cancelled. If the debt is not paid, the trustee may sell the property. The lender must give the trustee proof that the debt is delinquent and ask the trustee to foreclose. Foreclosure typically bypasses the court system.
To obtain a mortgage, a borrower first must qualify for the loan. Most lenders require a debt-to-income ratio of 28/36. This means that no more than 28 percent of the borrower’s income may go toward the mortgage payments and no more than 36 percent may go toward the mortgage payment and all other outstanding debts.
Once the borrower meets this requirement, most lenders require the buyer to make a down payment on the loan. This amount varies depending on factors such as income and credit history. The riskier the loan is for the lender, however, the higher the down payment is likely to be.
One option for borrowers who cannot afford a large down payment is an FHA loan. For this type of loan, the Federal Housing Administration allows borrowers to make a small down payment and then guarantees the lender that it will pay the loan if the borrower defaults. Almost anyone can qualify for an FHA loan, but the FHA limits how much may be borrowed.
Generally, second mortgages come in the form of a home-equity loan, in which the borrower uses the equity in his or her house as collateral. Just like in a first mortgage, a lien is created against the borrower’s property. A lien is simply a legal claim that the lender has in case the borrower defaults. While second mortgages are common, it is rare that a borrower could get a third or fourth mortgage on the same property. Additionally, second mortgages tend to come with higher interest rates because the loan is riskier for the lender.
A problem with multiple mortgages arises when the borrower defaults on one or both loans. If that happens, the first lien holder (the first lender) has priority over the second lien holder (the second lender) and may initiate foreclosure proceedings. The first lender has a right to all of the money due under the mortgage contract. This is true even if the borrower continues to pay on the first mortgage but defaults on the second. While the second lender may foreclose on the house, the first lender still has priority.
Last update: Oct. 29, 2008
